Signaling Firm Performance Through Financial Statement Presentation: An Analysis Using Special Items The Harvard community has made this article openly available. Please share how this access benefits you. Your story matters Citation Riedl, Edward J., and Suraj Srinivasan. "Signaling Firm Performance Through Financial Statement Presentation: An Analysis Using Special Items." Contemporary Accounting Research 27, no. 1 (spring 2010). Published Version http://onlinelibrary.wiley.com/doi/10.1111/ j.1911-3846.2010.01010_8.x/full Citable link http://nrs.harvard.edu/urn-3:HUL.InstRepos:29660926 Terms of Use This article was downloaded from Harvard University’s DASH repository, and is made available under the terms and conditions applicable to Other Posted Material, as set forth at http:// nrs.harvard.edu/urn-3:HUL.InstRepos:dash.current.terms-of- use#LAA Signaling Firm Performance Through Financial Statement Presentation: An Analysis Using Special Items Edward J. Riedl * Harvard Business School Suraj Srinivasan Harvard Business School ABSTRACT: This paper investigates whether managers’ presentation of special items within the financial statements reflects economic performance or opportunism. Specifically, we assess special items presented as a separate line item on the income statement (income statement presentation) to those aggregated within another line item with disclosure only in the footnotes (footnote presentation). Our study is motivated by standard-setting interest in performance reporting and financial statement presentation, as well as prior research investigating managers’ presentation choices in other contexts. Empirical results reveal that special items receiving income statement presentation are less persistent relative to those receiving footnote presentation. These results are consistent across numerous alternative specifications. Overall, the findings are consistent with managers using the income statement versus footnote presentation to assist users in identifying those special items most likely to differ from other components of earnings―that is, for informational, as opposed to opportunistic, motivations. Keywords: special items, strategic reporting, presentation, voluntary disclosure, pro forma We thank the following individuals for their useful comments and discussions: Bill Baber, Ray Ball, Phil Berger, Mark Bradshaw, Jeffrey Callen (the editor), Patricia Fairfield, Michael Kimbrough, S.P. Kothari, Ben Lansford, Roby Lehavy, Asis Martinez-Jerez, Greg Miller, Ray Pfeiffer, Doug Skinner, Mohan Venkatachalam, Jim Wahlen, Greg Waymire, two anonymous reviewers, and seminar participants at Georgetown University, Harvard Business School, University of Massachusetts – Amherst, Michigan State, the UNC/Duke Fall Camp, Stanford University, and the AAA 2006 Annual meeting. We gratefully acknowledge the contribution of I/B/E/S International Inc. for providing earnings-per-share forecast data, available through the International Brokers Estimate System. These data have been provided as part of a broad academic program to encourage earnings-expectation research. We also thank Claire Chiron, Maylene Han, Susanna Kim, and Grace Lin for excellent research assistance. The paper was previously titled “The Strategic Reporting of Special Items: Does Management Presentation Reflect Underlying Firm Performance or Opportunism?” * corresponding author: Morgan Hall 365 Boston, MA 02163 617.495.6368 617.496.7363 fax [email protected] Electronic copy available at: http://ssrn.com/abstract=923898 Signaling Firm Performance Through Financial Statement Presentation: An Analysis Using Special Items ABSTRACT This paper investigates whether managers’ presentation of special items within the financial statements reflects economic performance or opportunism. Specifically, we assess special items presented as a separate line item on the income statement (income statement presentation) to those aggregated within another line item with disclosure only in the footnotes (footnote presentation). Our study is motivated by standard-setting interest in performance reporting and financial statement presentation, as well as prior research investigating managers’ presentation choices in other contexts. Empirical results reveal that special items receiving income statement presentation are less persistent relative to those receiving footnote presentation. These results are consistent across numerous alternative specifications. Overall, the findings are consistent with managers using the income statement versus footnote presentation to assist users in identifying those special items most likely to differ from other components of earnings―that is, for informational, as opposed to opportunistic, motivations. 1 Electronic copy available at: http://ssrn.com/abstract=923898 Signaling Firm Performance Through Financial Statement Presentation: An Analysis Using Special Items 1. Introduction This paper investigates whether managers’ presentation of special items within the financial statements reflects informational versus opportunistic motivations. The presentation decision we examine is whether management disaggregates special items as a separate line item on the income statement (income statement presentation) or aggregates them into another line item with identification only via footnote disclosure (footnote presentation). Under both presentation choices, the special item is recognized, i.e., reflected in net income. By informational motivations, we suggest managers use the income statement versus footnote presentation as a mechanism to assist users in better understanding the economic implications of the reported special items. By opportunistic motivations, we suggest managers use this presentation decision to bias perceptions of the firm’s performance. To distinguish between these motivations, we follow prior research and examine the mapping of special items into the firm’s future performance: that is, the persistence of reported special items (Burgstahler, Jiambalvo, and Shevlin 2002). We predict that informational motivations are revealed by correspondence between the reporting signal (i.e., the presentation choice) and the economic signal (i.e., the economic performance of the reported special items). That is, informational motivations suggest that those special items receiving income statement presentation are less persistent relative to those receiving footnote presentation. In contrast, we predict that opportunistic motivations are revealed by a lack of correspondence between the presentation choice and economic performance of the reported special items. That is, opportunistic motivations suggest that those special items receiving income statement presentation are more persistent compared to those receiving footnote presentation. 2 Electronic copy available at: http://ssrn.com/abstract=923898 Our study is motivated by academic interest in manager disclosure decisions generally (e.g., Healy and Palepu 2001), as well as literature examining disaggregation (Dye and Sridhar 2004) and the characteristics of permanent versus transitory components of earnings (e.g., Brooks and Buckmaster 1976; Elliott and Hanna 1996). These papers provide evidence that disaggregation of elements with differing implications for firm performance improves the information set about the firm. In addition, our paper is motivated by standard-setter interest in financial statement presentation, which arises from the flexibility managers have in these reporting choices and the potential implications of these choices for financial statement users (FASB 2006; IASB 2006). Consistent with this perspective, our study is also motivated by experimental evidence that financial statement presentation choices can affect user judgments (e.g., Hirst and Hopkins 1998; Maines and McDaniel 2000). We choose managers’ presentation of special items on the income statement as our experimental setting for the following reasons. First, special items have been shown to have differing properties relative to other components of income (e.g., Lipe 1986), suggesting differential presentation in the financial statements may assist users in understanding their properties. Second, special items have been increasing in frequency and magnitude over time (e.g., Elliott and Hanna 1996; see also Appendix A), suggesting they are economically significant reporting elements. Further, financial reporting standards have recently incorporated additional reporting elements―particularly those relating to fair value accounting―likely to have similar attributes to the special items we examine.1 Third, prior research demonstrates that special items are heterogeneous across a number of characteristics (e.g., Francis, Hanna, and Vincent 1996; Burgstahler, Jiambalvo, and Shevlin 2002), providing cross-sectional variation that we exploit in 1 For example, special items tend to have lower serial correlation than other components of earnings. Similarly, changes in fair value have (in expectation) low or zero serial correlation. 3 our empirical examination. Finally, we conjecture that special items provide a strong setting for examining motivations underlying managers’ financial statement presentation choices, as the reporting of special items typically reflects substantial inherent uncertainty (e.g., the success of a restructuring) and measurement error (e.g., estimation of impaired goodwill). Our empirical tests use hand-collected data spanning 1993-2002 for a sample of 500 U.S. firms within the S&P 1500. Data are collected to enable